TARGET FINANCIAL INDEPENDENCE AND TAKEOVER PRICING

• Published date: 01 September 2015
• Author: Jan Jindra,Thomas Moeller
• Date: 01 September 2015
• DOI: http://doi.org/10.1111/jfir.12064

TARGET FINANCIAL INDEPENDENCE AND TAKEOVER PRICING

Jan Jindra

U.S. Securities and Exchange Commission

Thomas Moeller

Texas Christian University

Abstract

In a large sample of U.S. takeovers, we find that acquisitions of targets with greater

financial independence are associated with higher takeover premiums and lower

acquirer announcement returns. This empirical result is most consistent with targets’

deriving bargaining power from their financial independence. Raising external funds is

costly. Targets that do not depend on external funds do not need new external capital and

have no reason to acquiesce potential takeover premium to acquirers that can provide

capital. Therefore, more financially independent targets should be in stronger bargaining

positions vis-

a-vis potential acquirers, leading to the effect on takeover pricing that we

observe.

JEL Classification: G34

I. Introduction

Takeover outcomes, in particular the prices, are the result of negotiations that should

reflect the bargaining power of the parties involved. However, bargaining power is a

broad concept that is difficult to measure and likely derives from several sources. Here,

we focus on target firms’bargaining power derived from their financial characteristics.

We argue that more financially independent targets have stronger bargaining positions

because they likely do not need any external funds that acquirers can provide. Although

we are not the first to argue that firms’financial characteristics affect transaction prices

(e.g., Shleifer and Vishny 1992; Pulvino 1998; Officer 2007), we are the first to

comprehensively study the effects of target financial characteristics on acquisition

pricing in a large sample of takeovers of public targets.

We thank an anonymous referee, George Alexandridis, Natasha Burns, Eric De Bodt, Craig Doidge, Vince

Intintoli, Raghu Rau, seminar participants at the University of Hong Kong, the University of Texas at Arlington,

Southern Illinois University, as well as conference participants at the 2012 FMA Asian conference and the 10th

Paris International Finance meeting (2012). Thomas Moeller wishes to thank the Neeley Summer Research Awards

program and the Luther King Capital Management Center for Financial Studies at the Neeley School of Business at

TCU for their financial support for this research. Jan Jindra notes that the Securities and Exchange Commission, as

a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The

views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the

author’s colleagues upon the staff of the Commission. All errors are our own.

The Journal of Financial Research Vol. XXXVIII, No. 3 Pages 379–413 Fall 2015

379

© 2015 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

The existing literature on acquisitions sometimes controls for certain target

financial characteristics. However, many financial characteristics have alternative

interpretations. For example, raising external capital can indicate easy access to external

funds (strong bargaining position) or pressing need for external cash to finance

operations (weak bargaining position). Not surprisingly, existing studies that control for

target financial characteristics report mixed results. For example, Smith and Kim (1994)

report that acquisitions of targets with both high operating income-to-assets ratios and

high-growth opportunities have significantly higher acquirer announcement returns. In

Wang and Xie (2009), target return on assets is not related to acquirer announcement

returns. Bauguess et al. (2009) report that target return on assets is positively related to

target relative gains while target operating cash-flow-to-sales has the opposite effect.

They also find a negative effect of target operating cash flows on premiums and a positive

effect of target return on assets on premiums, albeit both are statistically insignificant.

Bargeron et al. (2008) show insignificant effects of target operating cash flows on

takeover premiums. Because these studies do not specifically focus on bargaining issues

arising from targets’financial characteristics, they tend to treat these variables purely as

controls. Therefore, the lack of consistent interpretation is not surprising.

We propose that the interplay between a firm’s reliance on external versus

internal sources of financing, its availability of internal funds (cash), and its investment

activities affect its exposure to market disruptions, industry shocks, and variations in its

own credit quality. Following this rationale, we focus on a relatively clear-cut indicator

of target financial characteristics, the degree to which the target can fund its operations

through its cash holdings and internal cash flows versus its dependence on external

capital markets. We call this measure Financial independence. Negative target Financial

independence indicates that the firm would have been unable to finance its operations

without resorting to raising external capital.

Financial independence is based on the most prominent, well-established

(in)dependencevariables in the literature, Rajan and Zingales’s (1998) equitydependence

(net amount of equity issues/capital expenditures) and financial dependence ((capital

expenditurescash flows from operations)/capital expenditures). Our Financial

independence variable, described in detail in Section III, adds cash holdings to the

definition of independence. Cash holdings are not captured by the Rajan and Zingales

measures, but they are arguably a critical component of a firm’s independence from

external sources of funds. Because Rajan and Zingales are interested in a long-term

measure of fundamental dependence, they can ignore the typically transitory cash

holdings. They calculatetheir measures as decade averages and thenuse industry medians

as their main variables.In contrast, our Financial independenceis a time- and firm-specific

measure. We contend thatfunding shortages that may only last a few years can stillcause

substantial problems for firms and that such issues should affect acquisition pricing.

We propose that all else equal, a target with low (negative) financial

independence is more likely in a weak bargaining position vis-

a-vis a potential acquirer

and is more likely to accept a takeover at a discounted price. Although the target can

potentially issue equity or debt when in need of capital, raising external capital is costly

and the ability to access capital markets may vary over time, thereby adding to the

target’s bargaining disadvantage. Some of the takeovers likely occur (and our results

380 The Journal of Financial Research

obtain) precisely because for the target giving up a fraction of takeover premium is less

costly than raising external capital.

The example of the Anchor GamingInc. acquisition of Powerhouse Technologies

Inc. in March 1999 illustrates our argument. Two years before the acquisition

announcement, Powerhouse Technologies was able to finance its operations mostly

through internalcash flows, while it relied predominantly on externalcapital markets in the

next year, that is, the year leading up to the acquisition. Powerhouse Technologies’chief

financial officer specifically commented on the role of the takeover as a source of

financing: “This gives us greataccess to capital.”

1

The acquisition was characterized by a

target premium of only 5.9% and a positive acquirer announcement return of 6.2%.

Although Powerhouse Technologies was likely not financially constrained in the year

leading up to the acquisition,as its operating cash flows equaled10.2% of assets and it was

able to raise externalfunds as recently as five months before the acquisition announcement,

it needed external funds to finance its operations that year. Therefore, the acquisition

pricing in this illustrative example is consistent with targets’current financial needs and

reliance on external financing weakening their bargaining power.

Although bargaining power should have first-order effects on takeoveroutcomes,

the existing liter ature on target financial characteristics or bargaining power affecting

takeover pricing is scarce. Most of the literature on bargaining in takeovers examines

principal–agentconflicts (e.g., Hartzell, Ofek,and Yermack 2004; Moeller 2005),takeover

defenses (e.g., Comment and Schwert 1995; Subramanian 2003), or bidding strategies

(e.g., Betton andEckbo 2000). We provide evidence on target financialcharacteristics and

bargaining power affecting takeover pricing in this article. Consistent with the bargaining

power hypothesis, targets with low financial independence are associated with low

takeover premiums andhigh acquirer announcement returns. Both effects are statistically

significant and economically meaningful. A one-standard-deviation increase in target

financial independence increases takeover premiums by 3.9%(from an average of 29.1%)

and decreases acquirer announcement returns by 0.3% (from an average of 1.5%).

2

Our aim is similar to Ahern’s (2012) in that we examine the effect of proxies for

bargaining power on takeover outcomes. One key difference is that Ahern (2012)

measures bargaining power with industrywide customer–supplier relationships between

targets and acquirers whereas we use target-specificfinancial independence. Despite

being firm specific, our measure is also easier to construct from standard databases (e.g.,

Compustat) than Ahern’s.

The drawback of our measure of financial independence being firm specificis

that it is potentially subject to endogeneity biases. Because takeovers are relatively rare

1

Sheila M. Poole, “Lottery Operator Powerhouse Sold Jackpot: Las Vegas Firm Anchor Gaming Will Enter

the Online Business, Buying the Metro Atlanta Firm in a Deal Worth $280 Million,”The Atlanta Constitution,

March 11, 1999, p. C1.

2

All else equal, acquirers should pick a financially dependent over a financially independent target. Yet, all

else is usually not equal. Targets can be desirable for a number of reasons, for example, strategic fit, cultural fit,

synergies, and private benefits for acquirer managers. What we observe is that, on average, when the desirable

target happens to be financially dependent, acquirers get a better deal. The answer to the broad question why

acquirers make acquisitions that result in negative acquirer announcement returns is beyond the scope of our article,

but popular explanations revolve around hubris and principal–agent conflicts.

Target Financial Independence 381